Strong U.S. economic growth, the advent of industrial policy and the arrival of expansionary fiscal policy next year have all caused the greenback to soar in value recently, with more increases on the way.
But the dollar’s strength is coming at price for emerging markets, which must pay more to service their external debt. If the dollar overshoots any reasonable valuations, then those economies that have seen a notable rise in external debt will fall under greater stress.
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These strains on emerging markets are not likely to ease anytime soon as a new administration prepares to take over in the U.S.
The use of external debt, or issuing domestic debt payable in a foreign currency, as a funding mechanism has grown in step with the development of the global financial sector.
In the four decades after the free-floating of the dollar in 1972-73, the use of external debt reached $40 trillion before the financial crisis.
External debt drifted lower as the global economy recalibrated, but has since approached $45 trillion as of the second quarter.
External debt has its risks. This external debt is subject to interest-rate shock, which occurred once U.S. interest rates moved away from the near-zero levels, and the currency shock that occurred as the U.S. economy recovered and as its interest rates normalized.
Since 2020, the dollar’s value has increased by 18%. That translates into a surcharge on external-debt repayments as high as 18%, depending on when the debt was issued.
That surcharge could rise notably in the coming year and strain those economies that lack sufficient foreign exchange reserves and fiscal buffers to weather the rise.
There is at least $2.3 trillion of outstanding external debt that is subject to further currency shock should the dollar continue to strengthen, according to the World Bank.
The dollar index has been range-trading in the two years after the 2022 peak in the dollar’s value, with its lower limit set by its long-term average of 100 and its upper limit reaching approximately 5% higher with a few recent exceptions. Whether this 100-105 range holds will most likely be determined by market reaction to U.S. trade policies.
Still, a substantial portion, or 59%, of the outstanding debt is subject to currency shock of increased payments caused by the dollar’s appreciation.
That data implies a non-trivial adjustment to the global economy in 2025 due to American policy changes.
